But, as promised last week, I’m going to use the Thursday edition of Money Morning to run a mini-series on technical analysis. I’m going to give you the tools to interpret any market price action even when the news headlines are defying belief. This series will improve your chances as you take your first steps into the world of online trading.
To follow along with the program, you can sign up for a demo account here.
Now working for South Africa’s #1 rated stockbroking firm, I get a lot of requests from clients wanting to know how to trade. It is not an easy question to answer. Successful traders take years to develop. But they all started somewhere and the techniques I’ll be discussing will help you interpret price action.
When I say, “price action”, I’m talking about movement in the actual share’s underlying price. You see technical analysis is all about analysing share price charts. Technical analysis allows you to ignore the complex fundamental drivers behind the share prices (like wild mainstream media headlines) and capitalise on trends and patterns. Technical traders might not understand why a stock always goes up in June, but they can recognise the pattern and take advantage.
Learning simple technical techniques very quickly gives new traders a powerful weapon in their trading arsenal.
In fact, I would say the ability to look at, read and analyse charts is absolutely core to short-term trading. Finding patterns, understanding indicators and identifying areas of support and resistance are essential if you want to place trades yourself.
But there’s no point jumping into the deep end if you don’t know how to swim.
Before we even get to the technical analysis, it is important to first cover the jargon that goes with trading. And equally important, you need to understand the risk! Once you have your head wrapped around all of that, then we can jump into the fun charting side of trading!
Let’s start with CFDs.
As you open almost any trading platform, you’ll notice immediately you have the option to trade the “Equity” or the “CFD”.
CFD stands for: Contract For Difference.
While “Equity” means ordinary shares.
What’s the difference?
CFDs are derivatives. A derivative is something that “derives” its price from something else. For example, the Naspers CFD “derives” its price from the underlying Naspers equity.
This means the Naspers CFD perfectly mirrors the price of actual Naspers equity exactly.
If CFDs and stocks trade at the exact same price, then why trade CFDs? There are many reasons.
CFDs are cheaper in terms of brokerage. This is very important to short-term traders who try to profit from small price movements and trade regularly. They also allow you to take short positions on a share and thus profit from falling prices.
Derivatives also give you “onscreen” access to investment products that can’t be traded electronically. Take gold for example. If you buy a gold CFD it perfectly mirrors the price of an ounce of physical gold. Pretty useful if you’re buying and selling gold all day.
Imagine how impossible it would be to trade physical gold 200 times in a day?!
That’s just an average Wednesday morning for an active trader.
The next important term for traders to understand is “leverage” or “gearing”.
The words can generally be used interchangeably.
It’s also a key concept in the difference between “Equity” and CFDs.
CFDs are leveraged (or geared) products. Equities are not.
To understand what a leveraged product is, think about taking out a home loan.
When buying a house, people usually benefit from the gearing or leverage effect. How?
When buying a house, people go to the bank, they put down a deposit, and borrow money to pay for the house.
A few years later, you sell the house for a profit. When they do, they return the money you borrowed to the bank and keep ALL of the increase in the value of the house. I’m trying to avoid using too many calculations, but this is important.
You buy a house for R1 million.
You put down a R100,000 deposit and borrow R900,000.
You wait a few years and sell the house for R2 million.
You repay the R900,000 and get R1.1million in cash.
You just used leverage to turn a R100,000 deposit into R1.1 million cash. You did that by using the bank’s funding to multiply your profit.
I’m assuming you’re been diligent and serviced only your interest payment over the period. In trading these are called “swaps” or “carry” and that are also important to understand.
The interest rates of the day dictate how high your swaps are on the money you borrow. Fortunately, we’re in a situation currently where interest rates have been slashed to near zero in the world. This makes leveraged trading much cheaper and more attractive than it was, let’s say a year ago.
So, let’s go through another example. This time instead of using a house, I’m going to show you how it works with stocks and CFDs.
When you trade a CFD, it has a “margin” amount. This term “margin” is the same as the deposit you put down on the house. Only now you’re “posting margin” to buy shares instead of property.
If a Naspers is trading at R2,000 a share and the “margin” on a Naspers CFD is 10%, you only need to put down R200 for every CFD you trade. Another way of stating this is that Naspers CFDs are 10 times geared.
In this example the CFD provider (also sometimes called the “counterparty”) will lend you the other R1800.
If Naspers goes up 50% (which would mean it moves to R3000 per share) you would get a 500% return on your margin amount.
You posted a R200 margin. And now you pay the counterparty back the R1800 they lent you and you get R200 margin back plus the profit or R1000.
You started with R200 and now you have R1200. You make five times your margin in profit.
Another reason traders prefer CFDs to Equity is this multiplication effect.
If you have R10,000 in your account, you can trade 50 Naspers CFDs as opposed to being able to only buy 5 Naspers equities. Leveraged products like CFDs you can trade much larger quantities.
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It’s important to note: This multiplication works both ways. If you get the direction of the trade wrong, you’re going to lose money at an exaggerated rate too!
This introduces the idea of “stop losses”. A stop loss is exactly what it says. It stops your loss when a position has fallen too far.
The opposite of a “stop loss” is a “take profit”. A take profit is the level you aim for when you’re ready to get out and bank you trade.
One of the biggest reasons why traders prefer to trade CFDs as opposed to trading the actual equities is the capital efficiency. The “swap” or “carry” interest is actually quite low when compared to other forms of borrowing. It’s often more efficient to gear against a share portfolio than a property.
In other words, it can be cheaper to release cash from your ordinary equity by gearing it and paying down debt on property. This depends on your personal borrowing rate, but it’s worth looking at on larger accounts.
Many listed company directors use derivative structures like zero cost collars to release cash from their share portfolio to be used elsewhere.
There are a lot of tax advantages as well if you do it correctly. But that discussion is outside the scope of today’s article.
If you want to know more just drop an email to email@example.com
and one of our wealth managers can chat you through the implications of correct hedging.
Next week, I’m going to get into the ins and outs of risk management. And the week after we’ll start with the basic technical concepts!
Rand Swiss, Private Client Trader